Coronavirus and the Misbehavior of Markets

Markets do not follow the tidy statistical model most people have come to think they do. For example, this week (February 24-28, 2020) has seen the biggest declines since the 2008 market collapse. The potential disruption from the coronavirus that is now sweeping the world has been known for over a month, and yet asset prices waited until this week to plunge.

The mathematician Benoit Mandelbrot (1924-2010) wrote extensively on the movement of asset prices over a long career. One of his last works, “The Misbehavior of Markets” undercuts the common view that asset prices change in accord with a normal, or Gaussian, distribution. This is not just his opinion.  It is backed up by decades of study of asset prices of commodities, currencies, equities and bonds.

Viewing “risk” as the variability of asset prices, markets are considerably “riskier” than would be predicted by a normal (Gaussian) distribution of price changes.  Mandelbrot wrote, “The seemingly improbable happens all the time in financial markets.” “Price fluctuations can be…far greater and more damaging than the mild variations of orthodox finance.”

Mandelbrot commented on Eugene Fama’s review of stock prices for his doctoral thesis:

“Whatever the stock index, whatever the country, whatever the security, prices only rarely follow the predicted normal pattern.  (Page 95)

“Large changes, of more than five standard deviations from the average, happened two thousand times more often than expected.  Under Gaussian rules, you should have expected such drama only once every seven thousand years; in fact, the data showed, it happened once every three or four years.” (Page 96)

Commenting on the wave of bankruptcies after Long-Term Capital Management’s collapse in 1998: (via WSJ) “With globalization increasing, you’ll see more crises. Our whole focus is on the extremes now – what’s the worst that could happen to you in any situation – because we never want to go through that again.” (Page 108)

In his book, Mandelbrot shows mathematically how the movement of markets is more akin to the effects of wind, or the raging of flood waters.

Individual investors must consider that there will be wild swings when constructing investment portfolios.  Markets are considerably more dangerous than anyone imagines.

Where does this end? What is the worst that could happen? Nobody knows.  But at some point, this storm will be over and the sun will come out again.

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